Prophets of doom: the coming oil crisis

The world economy has gotten fairly comfortable with oil at $45 a barrel. But how will it react to paying $100 a barrel three years from now? Or $150 in five years?

That's what the future holds according to Stephen Leeb, president of Leeb Capital Management and author of The Oil Factor (Warner Books 2004). The result, Leeb says, will be double digit inflation--if we're lucky. If we're not, it will be a severe depression. We asked Leeb to explain the gilding of black gold.

You say the price of oil will rise much higher than it already has. Why?

"The problem we have is that there are 2.3 billion people in Chindia," Leeb says, using shorthand for a combined China and India. "Today, China and India use the energy-equivalent of 5.5 barrels of oil per person per year, while rich nations use 39. No matter how rosy your thinking is as to the global supply of oil, there is no way there is going to be enough to satisfy the demands of an extra 2.3 billion people coming online."

As China and India become rich nations, the demand for oil could grow at 6% per year, compared to 2% recently. Currently, the world has almost no excess supply. The planet is operating at anywhere from 95% to 99% capacity, Leen says. "There is no margin for error." The only way the system can respond is continued price increases.

How bad will it get?

At the end of 1999, oil was trading for around $10 a barrel. Since then, it has risen by about 29% per year. Simply extending the trend line means that oil will be at $100 a barrel in about three years and at $160 in five years, Leeb says. If prices rise the way they have in the last year, the resulting levels will be even higher, and that's without any major geopolitical crisis in the Persian Gulf or anywhere else. "It's not a heroic position," Leeb says. "But I don't know how you avoid it."

What will the result be?

We'll see historically high inflation of 11% to 15%, according to Leeb. "That's not even so unusual," Leeb says. He notes that the U.S. has had bouts of inflation at that level during the two world wars and in the 1970s at the tail end of Vietnam.

"We're kind of overdue," he says.

Economically, the U.S. is already on a kind of war footing, with the war on terror, Iraq, massive military spending and a shortage of a key commodity, specifically oil.

"I hope I'm wrong," he says. "I've never wanted to look more like an idiot than I do right now. But I don't see it."

The "optimistic" side of the scenario is that you can live with high inflation, and even make money with the right investment strategy. Leeb favors oil stocks like ExxonMobil (nyse: XOM) and BP (nyse: BP) and traditional hedges like real estate, and is especially high on oil service stocks like Schlumberger (nyse: SLB) and Transocean (nyse: RIG).

When and why will it bottom out?

"I don't see it bottoming out soon," he says. " I think it's a decade- or generation-long problem. A depression would stop it. But as long as the Federal Reserve keeps real interest rates negative, that can be avoided."

The better outcome may be that "as energy prices continue to rise, we'll organize a worldwide effort to develop alternative energies," Leeb says. "Maybe that will even bring the world together."

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